Ynetim ve Ekonomi, Celal Bayar University, Journal of Economics & Administrative Sciences, Year:1999, No:5, pp.367-378.

THE IMF AND WORLD BANK APPROACHES TO MACROECONOMIC MANAGEMENT IN DEVELOPING COUNTRIES Huseyin SEN*
Abstract:An half a century has just passed since the creation of the Bretton Woods Institutions, the IMF and World Bank. As in the past decades, both institutions are still on the economic as well as political agenda of a number of countries, in particular, developing countries. This paper gives the analytical descriptions of both the IMF and World Bank approaches to macro-economic management in LDCs. zet: Bretton Woods KuruluODU olan IMF ve Dnya Bankasnn kurulmasndan bu tarafa yarm yzyldan daha uzun br sre geti. Gemis yOODUGD ROGXX JLEL KHU LNL NXUXOXta hala ok sayda lkenin ekonomik ve siyasi gndeminin ba kseinde durmaktadr. Bu alma, gelimekte olan lkelerde IMF ve Dnya Bankasnn makroekonomik ynetime yaklamnn bir analitik tanmlamasn yapmaktadr.

I. Introduction: The IMF and World Bank were created at the Bretton Woods Conference in July 1944 by the delegation of 44 nations, along with a system of rules that have governed the world economy for more than fifty years. The IMF has played a key role in ensuring price stability, strengthening the balance of payments (hereafter BOP) and provision of loans to countries needing assistance. As for the World Bank, it was initially known as the International Bank for Reconstruction and Development (IBRD) was established to help industrial countries rebuild after World War II. Later the World Banks body was expanded and now it contains in its body, apart from IBRD, the International Finance Corporation (IFC), and International Development Association (IDA). The World Bank took a dual role of reconstruction and development. The development aspect was on long-term basis in which the Bank lend funds to developing countries in need. Following the economic problems of developing countries (hereafter LDCs) in the 1970s (oil price shocks in 1973-74 as well as 1979-80, decline in terms of trade, debt crisis in 1979-80s, fiscal deficits and high inflation), the two institutions formulated structural adjustment programmes designed specifically to resolve the economic problems of LDCs. The problems can be traced initially to the collapse of the Bretton Woods exchange rate system in 1971, which contributed to the volatility of the exchange rate. Since 1980s, the IMF and World Bank have played key roles in planning and management of LDCs. This paper discusses the basic nature of both the IMF and World Bank approaches to macroeconomic management in LDCs which constitutes their approaches to macroeconomic stabilisation and structural adjustment programmes. II. The Bretton Woods Institutions and Macroeconomic Management: Perhaps the IMF and World Bank are the first twin organisations which represent an important attempt in the history of economics to apply scientific conception of economic forces to the world economy through their stabilisation and structural adjustment programmes. With these programmes, both the IMF and World Bank deal with economic issues and focus their efforts on broadining as well as strengthening the economies of their member nations.

Research Assistant, Dokuz Eyll University, Public Finance Department, Buca-Izmir.

Macroeconomic management consists of stabilisation and structural adjustment programmes. Whilst stabilisation programmes are generally associated with the IMF, structural adjustment is dealt with by the World Bank. The IMF focuses primarily on BOP management, the World Bank, on the other hand, gives priority to the longer-term development of an economy. The IMF pays an important attention to monetary and fiscal policy, exchange rate management and foreign borrowing. As for the World Bank, it is charged with a countrys development objectives, such as mobilisation of domestic resources, improving efficiency in resource allocation, reform in the structure of economic incentives and institutional reforms. The IMF approach to macroeconomic management centres around monetary variables whereas the World Bank approach focus mainly on real variables of the economy. Briefly, the main differences between the IMF and World Bank can be shown in the following Box.
Box-1: The main differences between the IMF and Word Bank In terms of ...
Character Orientation Goal Credit

The IMF
Monetary institution Demand side of the economy Monetary stability Financing temporary deficits in the BOP Providing programme lending to all membersboth industrial and developing countries. Short-term / medium-term

The World Bank

Developmental institution Supply side of the economy Promotion of economic development Financing economic development Providing project lending to developing countries Long-term

Credit term

Kaynak: Derived from Murinde (1996:78) and IMF (1996)

The following sections explore both the IMF and World Bank approaches to macroeconomic management in LDCs. III. The IMF Approach to Macroeconomic Management: The IMF approach to macroeconomic management shows itself in the IMF programmes. These programmes represent an orthodox responce to macroeconomic imbalances of LDCs (Murinde,1993;Killick,1995;Weiss,1995;Murinde,1996;Polak,1997). Macroeconomic imbalances in an economy may stem usually from, either the prevalence of inflation and deficits in BOP or low rates of employment and growth, or both of them. In the IMF approach to macroeconomic stabilisation, it is assumed that these imbalances are generally caused by an excessive or unsustainable expansion of aggregate demand. In the literature, the IMF programmes are frequently called as orthodox stabilisation programmes. According to orthodox stabilisation programmes, the main cause of inflation and deficits in a countrys BOP is the resource-expenditure imbalance of that countrys public sector. In the developing country context, public sector expenditures are much higher than its revenues and thus fiscal deficits are largely financed through increasing money supply. Increase in money supply would lead to expansion of aggregate demand and thus increase in inflation. With the accelaretion of inflation, imports of foreign good and services would be cheaper relative to domestic good and services while exports more expensive. As a result, domestic demand for foreign good and services would increase while foreign demand for domestic good and services decreases. These developments would lead to a deficit in the BOP. For this purpose, as an anti-inflationary policy, general price level must be reduced by restricting money supply and credit to both public sector and private sector. Similarly, deficit in BOP stems from excessive expenditure of public sector. Therefore, in order to have a sustainable BOP, public expenditure must be reduced. In the IMF approach to macroeconomic management, under the assumption of a stable aggregate supply function, variations in aggregate demand are considered to be major factors behind the short-term fluctuations in output, prices and the BOP (Buira, 1983:118).

In short, orthodox stabilisation programmes, which reflect the IMF approach to macroeconomic management, require the use of tight monetary and fiscal policies to restrain aggregate demand in order to achieve macroeconomic goals, such as a viable BOP and price stability in the medium-term, which are seen a necessary condition for long-term sustainable economic growth. While the programme vary in their details, however, their common thrust is to restore BOP while maintaining and strengthening the conditions for achieving a satisfactory rate of long-term economic growth in a non-inflationary manner. Underpinning the IMF approach to macroeconomic management is built around the following macroeconomic accounts (IMF,1987; Tarp,1993): National account: External balance : Monetary balance: Fiscal balance1 :
Where, Y = national income, I = investment X = export Z = import . = the changes in the variable R = foreign reserves M = money stock DC = the credit to the both private sector and the government sector, INP = interest payments from the government and the private sector to the foreign sector, NTR = net transfers to the domestic to the government and the private sector, NFA = the accumulation of net foreign assets against the domestic economy, NPB = net public borrowing Sg = government savings, and Ig = government investment.

Y = C + I + (X-Z) R = NFA = (X-Z) - (INP -NTR) M = R + DC Sg - Ig = NFAg - NPBg DCg

[1] [2] [3] [4]

These accounts serve several important functions: first, the data are useful in the assessment of the state of the economy and the determine the need for an adjustment policy; second, provide a framework for the model of macroeconomic performance that gives the logical structure to any macroeconomic programme, and finally, provide a check for forecasts and policy packages. The IMF approach splits the economy into four sectors as, private non-financial sector, government sector, banking sector and the foreign sector. The accounting relationships which is shown in the flow of funds account, highlight the fact that any sectors spending beyond its income must be financed by the savings of the other sectors and that such excess spending by an economy is possible only when it is financed by net saving from the foreign sector (recorded in foreign sector account). The IMF mandate ensures that the use of its resources by a beneficary country is linked to a policy programme that leads within reasonable time to a viable BOP position. Therefore, the analytical framework underlying the IMF programmes focuses on the BOP and its various components as well as overall macroeconomic developments. The earlier version of the IMF approach to macroeconomic management was based on the absorption approach2. It was later integrated and expanded by Polak in the late 1950s - known as the Polak Model3. This model constitutes the pillar of the IMF approach to macroeconomic management.

Fiscal balance identity expresses the government budget contraint. Absorption Approach combines the national accounts balance and the external balance. 3 Polak Model takes its name from Jacques J. Polak who is concidered to be the founding father of the IMF approach to macroeconomic managament. The model is based on a small open economy with fixed exchange rate. The model integrates monetary and credit factors into the BOP and thus derive a relationship between domestic component of the money stock (domestic credit) and changes in foreign reserves.
2

The IMF itself later expanded the Polak model on the development of the monetary approach to the BOP. The approach has been identified as the theory underlying the IMF financial programming framework. Financial programming is the core of the theoretical and practical aspects of the IMF management programmes in LDCs. Since 1950s, it has been making up of the backbone of the analysis leading to IMF conditionality, which is the policy actions that a borrowing country aggrees to follow as a condition for providing IMF credit (Polak, 1997). Financial programming is an accounting framework that integrates a system of accounts, including national income and expenditure, current and capital accounts of the BOP, accounts of the central bank, the banking system and the government. These accounts are all integrated into the flow of funds account and the monetary survey of the central bank. Consequently, the basic structure of the IMF programmes is built on a financial analysis that ensures consistency between the impact of proposed policy measures and the desired BOP outcome (IMF,1987). The financial programming framework links the financial sector with the BOP as illustrated by the following identities: Y = GDP - NF GDP = C + I + ( X - Z ) DA = C + I CA = X - Z - NF
where, Y DA CA NF = national income, = domestic absorption, = the balance on current account of BOP, and = net factor payments to abroad.

[5] [6] [7] [8]

The substitution of [6], [7], [8] into [5] gives the following identity; Y = C+ I + (X-Z) - NF Y = C + I + (X-Z)-NF Y = DA + CA, and thus, CA = Y - DA [9]

This means is that current account deficit is simply equal to the difference between national income and domestic absorption. In addition, the equation highlights that the current account shows a surplus if income is greater than domestic absorption and a deficit in the reverse case. This information illustrates the important principle that a current account deficit can be reduced by a decline in absorption (relative to income) or by an increase in income (relative to absorption). Similarly, a change in reserves will be equal to the current account balance plus any net inflows of foreign capital (FI). Thus,

R = CA + FI,
where, R FI = the change in net foreign assets of the banking system, and = the change in the net inflow of foreign capital.

[10]

Combining equations [9] and [10] one obtains,

R = Y - DA + FI

[11]

which shows the excess of domestic absorption over income not financed entirely by foreign borrowing leads to a rundown of net foreign assets. Since the stock of such assets is limited in LDCs, the financing

of domestic absorption in this manner is greatly limited. It is noted that demand management policies directly influence domestic absorption and thereby the internal balance which refers to the conformity between aggregate expenditure (equal to absorption plus exports minus imports) and potential output at stable prices. From the monetary balance identity:

M = R + DC

[12]

The identity above shows a balance-sheet relationship for the banking system, where the change in domestic money stock is equal to the sum of changes in foreign and in domestic assets. It is also assumed under the approach that money demand4 is a function of income, prices and the opportunity costs of holding money, which takes the form:

M = f ( Y, P,..)

[13]

or rearranging to relate the change in nominal money (M ) to changes in nominal income (Y):

M = kY,
where, k = the inverse of the income velocity of money.

[14]

According to the equilibrium condition in the money market:

M = M

[15]

Hence, equations [12], [13], [15] can be combined to relate the change in net foreign assets, in which BOP is given by the difference between the change in money stock (equal to M) and the change in domestic credit (Tarp,1993; Polak,1997).

R = M - DC = f(y, ,....) - DC

[16]

The equation shows that a change in net foreign assets will be positive (BOP surplus) to the extent that the change in the total money stock exceeds the change in domestic credit. In the above equation real income is treated as exogenous. In the design of the IMF programmes, the implications of policies for both output and the price level are analysed carefully and output and inflation targets are major factors in deciding upon the policy package. Equation [9] shows that the gap between income and domestic absorption is equal to the current account. Further, the current account must be matched by the change in net foreign assets which is also equal to the difference between the change in the money supply and the change in domestic credit from the balance of the banking system, combining the equation gives:

4 In its approach to macroeconomic management the IMF assumes a stable demand for money. Therefore, the IMF approach may be seen as a monetarist model (see, Buira,1983:119).

CA + FI = M - DC substituting equation [9] to the equation [17] gives: Y - A + FI = M - DC

[17]

[18]

Given the overall financial programming framework, the relationship between change in net foreign assets and changes in domestic credit can be used in the design of a financial programme. The IMF uses expenditure switching or/and expenditure reducing policies to bring about a favourable BOP outcome. Exchange rate policy, hence devaluation is the main policy instrument to initiate expenditure switching policies, to change the composition of foreign and domestic expenditure between foreign and domestic goods. Devaluation can improve the external balance (R) by improving the competitiveness of domestic goods and services without at the same increasing the domestic absorption of all goods and services. Increase in the exports of goods and services due to improved competitiveness in the world market improves the current account balance of the BOP in terms of increased foreign exchange earnings. Expenditure reducing policies is targeted by placing ceilings on the expansion of domestic credit to the public and private sector. Restricting domestic credit (DC) is the main priority in the IMF stabilisation programmes. Restricting credit to the government is mainly associated with expenditure reductions (reducing subsidies, wage freeze, reduction in military budget) to improve the fiscal deficit. However, the expansion of domestic credit to finance the fiscal deficit leads to an increase in the money supply which could lead to the deterioration in the BOP and inflation. Contrastingly, devaluation increases the prices of imported goods and services. Most LDCs import intermediate inputs and capital for their production process. The increase in price of intermediate inputs is mainly passed on to consumers through increase in the price of final goods and services. Thus devaluation in itself is said to be inflationary. On the other hand, restricting the expansion of domestic credit in the banking system results in increases in interest rates. Increases in the interest rate raise investment costs, therefore investment is negated. Restraining investment leads to low capital formation, low growth and low employment creation. Thus, the IMF stabilisation programmes are said to be stagflationary in the short-term.

IV. The World Bank Approach to Macroeconomic Management: Following the reconstruction of the post-war Western European countries, a more and more attention has been given by the World Bank to providing finance for long-term growth and social development in LDCs. The Bank, thus, mainly provided funding for specific investment projects - project funding. However, the Banks policy agenda was changed significantly during the later period of the 1970s. Since then the bank has been charged with financing of growth and development over medium-term. The World Bank uses the Revised Minimum Standard Model (hereafter RMSM) in its approach to macroeconomic management. RMSM was designed in 1973 to set up a consistent approach to projections among countries. With the model, it is also aimed to faciliate comparisons among beneficary countires. The model is an expansion of the Harrod-Domar growth model that relates investment, imports and savings with output. RMSM is generally an accounting framework, linking the national accounts and BOP, with particular emphasis paid to the foreign financing gap and projections of foreign borrowing (Khan, et al., 1990). The model highligths the importance of the relationship among savings, foreign capital flux, investment and growth.

The framework initially used by the Bank in their empty framework are aggregated by the following identities: Production and Expenditure Balance: Income - Savings Balance: Savings and Trade Gaps: Y = C + I + (X - Z) Y=C+S I-S=Z-X [1] [2] [3]

From these identities, income is either used for savings or consumption. It is noted that investment must come either through domestic savings or the inflow of foreign capital (imports). Domestic savings is needed to finance targeted level of investment, however, given that most LDCs experience low levels of domestic savings, it implies that imports should be larger than exports. The greater share of imports in this instance would be made of investment goods or intermediate inputs to the production process. The identity also implies that foreign resources need to be injected in the economy for financing of investment projects. Financing of capital inflows could be from foreign reserves. However, if foreign reserves is limited, as is often the case in most LDCs, then foreign borrowing is utilised for such a purpose. This is expressed by the following identity: S - I = NFA + R,
where,

[4]

NFA implies additional foreign borrowing by the public and private sector NFB.

The two gap growth model is derived from the following identities. For a closed economy, real output: Y=C+I [5]

which implies that under equilibrium, ex-ante investment is equal to ex-ante savings. Saving is a function of real income: I = sY
where, I S =investment =marginal propensity to save

[6]

We know that I is equal to K, therefore the rate of capital accumulation is given by: g = K/K = s/k.
where, k = K/Y

[7]

Assuming, k is constant, the growth in real output (Y/Y) will be the same as the growth in capital stock. Thus, g = / = Y/Y = s/k5 [8]

5 Harrod-Domar Equation derived from the production function shows the relationship between quantity of production factors (capital, machinery to output).

The above equation basically relates to the Harrod-Domar equation, which shows that the rate of growth is determined by the savings rate and the capital-output ratio. The identity highlights that target growth in LDCss economies must save and translate these savings to effective investment. The growth rate also depends on the efficiency of investment which is measured by the incremental capital-output ratio (ICOR) or k. From equation [8], given the level of savings and investments, the rate of economic growth can be determined. The identity is used by the Bank as a planning tool to establish how much investment and savings is needed to attain a target level of growth, which is expressed as:

Y* = I/k,
where,

[9]
= target level of growth.

Y*

Since LDCs face savings constraint, then the required level of foreign borrowing to finance inflow of capital can be determined using the equation: S - I = NFA + R,
where,

[10]

NFA = NFB,

Thus the additional foreign borrowing required to finance capital inflows is given by:

NFB = kY* - sY +R = (R - sY-1 ) + (k - S) Y*.

[11]

Furthermore, given the trade gap experienced by LDCs the additional foreign borrowing by the private and public sector to close the trade gap is given as (Tarp, 1993):

NFB = m1 k y* + m2 y - X + R = (R - X + m2 y-1 ) + (m1 + m2 ) y*.

[12]

Tarp (1993) highlights four main equations which forms the theoretical core of RMSM:

Y = Y* I = kY* X = X Z = mY

[13] [14] [15] [16]

From equation [17] - [20] it is assumed that FI is determined by exogenous factors (FI= FI) and that import (Z) is dependent on exchange rate e and by z. Further, Tarp (1993) points out that in order to avoid the overdetermination of the model caused by the restriction on FI, the Bank made readjustments on k, s, and m parameters to obtain consistent projections. The Bank has also introduced the exchange rate as the key policy variable in the expenditure switching policy instrument of its structural adjustment programmes. It therefore, follows from equation [20] - [21], that taxes and public expenditures are controlled in the model to achieve BOP and output targets.

F = FI Z = my - ze R* = X - Z + FI R* = FI - mY* + ze + X

[17] [18] [19] [20]

Y* = 1/k - s - m (s + m)Y-1 + (1- s) T - Cg -X - ze)

[21]

The Bank programming and projections primarily focuse on real variables, rather than monetary variables. The projections on investment and savings are generally a planning aid to target the level of growth in the economy. Given the savings constraint of most LDCs, foreign financing is estimated to finance investment level that is consistent in achieving the targeted level of economic growth. V. Summary and Conclusion: The IMF approach to macroeconomic management is based on the financial programming model that relates the financial sector to the BOP. The policy instruments are mainly targeted to work on the monetary balance of the central bank. Ceilings on domestic credit through the increase in interest rates work on DC while the exchange rate policy (devaluation) works on the R to achieve a favourable BOP outcome and price stability. It is an accounting framework that integrates all variables and relationships in the macroeconomic accounts which are consolidated in the flow of funds account and the monetary survey of the central bank. The World Banks RMSM model is generally an accounting framework linking the national accounts and BOP, with particular emphasis paid to the foreign financing gap and projections of foreign borrowing when relating investment, imports and savings with target output growth. The Bank has tried to fill the foreign exchange gap through provision of structural adjustment loans (SALs) and sectoral adjustment loans (SECALs) to LDCs with some degree of conditionality. It must be highlighted that the both the IMF and World Bank models are only theoretical and empirical abstractions which is very difficult to synthesise with the real world behaviour of economic variables in LDCs, on which policy instruments are targeted. It is, therefore, prudent that during the IMF Article IV Consultations and the World Bank Mission Consultations, policy dialogue and consultation should be made thoroughly with LDCs. It is also important that for policy purposes the models and projections must be specified precisely.

VI. References: Buira, A. (1983), IMF Financial Programs and Conditionality, Journal of Development Economics, Vol:12, pp.111-136. IMF (1987), Theoretical Aspects of the Design of Fund-Supported Adjustment Programs, IMF Occasional Paper, No:55, Research Department of the IMF, International Monetary Fund:Washington D.C. IMF (1996), The IMF and the World Bank: How Do They Differ?, The IMF Economic Issues, International Monetary Fund: Washington D.C., pp.1-14. Khan, M.S, Montiel, P and Hague, N.U. (1990), Adjustment with Growth: Relating the Analytical Approaches of the IMF and World Bank, Journal of Development Economics; Volume 32, No:1, pp.158-178. Killick, T. (1995), IMF Programmes in Developing Countries: Design and Impact, Roudledge: London. Murinde, V. (1993), Macroeconomic Policy and Modelling for Developing Countries, Aldershot: Avebury. Murinde, V. (1996), Development Banking and Finance, Aldershot: Avebury.

Polak, J.J. (1997), The IMF Monetary Model: A Hardy Perennial, Finance and Development, December 1997. Tarp, F. (1993), Stabilisation and Structural Adjustment: Macroeconomic Frameworks for Analysing the Crisis in Sub-Saharan Africa, Routledge: London. Weiss, J. (1995), Economic Policy in Developing Countries:The Reform Agenda, Prentice Hall-Harvester Wheatsheaf: London and New York.

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